Generally speaking, the Ben-Stein-o-sphere is one corner of the financial internet from which I'm delighted to absent myself. Yves Smith is more courageous than I am in that regard, and while strolling the mean streets, he offers the following conjecture:

It is one thing to move the prices of single securities, quite another to move entire markets, particularly ones as big as the global equity markets and the US credit markets. We must have a simply staggering number of traders all conspiring together.

That's a perfectly commonsensical thing to say. But is it true? I don't know, but I think it's a fascinating question. Here's the pro and con as I see it:

Pro: By analogy with price impact behavior on individual securities, market indices should be well-nigh impossible to move. Generally speaking, the price impact of transactions is inversely related to the dollar trading volume of the traded issue and positively related to its volatility. It's much easier to move a thinly traded small-cap whose value has recently ranged all over the map than to move, say GE. Broad indices are by definition diversified (which reduces volatility), and the dollar trading volume of index components is gargantuan. Ergo, it should be very difficult to move indices.

Con: Perhaps the analogy between indices and issues is misleading. Indices can be traded as though they were single issues, via ETFs and futures, for example. But the market for such instruments is fragmented, and trading in any one is orders of magnitude thinner than the volume of the overall market it mimcs. An ETF or index future would be hard to move not so much by virtue of its own depth, but because it is bound by arbitrage to the price of the market as a whole. But the market as a whole has a great many degrees of freedom, and many stocks whose "true" values are uncertain. If one wants to materially move the price of a single issue, one probably has to push against "informed valuation" by investors who specialize in the stock's industry and are willing to take bets on relative pricing. But if one pushes against a whole index, arbitrage constraints can be resolved my moving many stocks only slightly, each issue remaining within the bounds of what would be considered noise by those who might trade a deeper mispricing. There's an elegance to this approach, in that the market itself determines an optimal path to resolve the disconnect created by the manipulator. Stocks for which there is a great deal of valuation uncertainty would move more than those whose prospects are clear, and the market manipulator avoids the transaction costs of trading these tens or hundreds of relatively illiquid issues herself. (Price-weighted or equal-weighted indices would be more vulnerable than value-weighted indices to this sort of attack, as smaller / less liquid / more volatile stocks have disproportionate sway.)

That's a nice theory, but would it work? I have no idea. If anyone out there has any insight into the question, hypothetically speaking of course, please do comment. It is frequently suggested that, while individual stock prices may be manipulable in the short-term, broad markets are immune. Is that right?

Felix Salmon writes, regarding this morning's heroic 75 bp rate cut:

Does this mean that all the talk of "Helicopter Ben" and the "Bernanke put" was justified all along? Well, yes... There's one reason and one reason only that the Fed took this move, and it's the plunge in global stock markets on Monday, along with indications that the US markets were set to follow suit.... [T]his action smells a bit like panic to me, and it might also have prevented the kind of stomach-lurching selling which could conceivably have marked a market bottom. I have to say I don't like it.

James Hamiltion responds:

I doubt very much that anyone on the FOMC has much interest in protecting the investments of stock market participants. Instead, I suspect that the Fed is using equity prices just as I and many other economic analysts do, namely, as a useful aggregator of private and public information about near-term prospects for economic growth. All the recent indicators have suggested a significant deterioration of real economic activity over the last two months. I take the global stock market sell-off as one more confirmation of that assessment, and new information about the global scope of the problems we face.

Hamiltion's interpretation is charitable, too charitable to fit the evidence. If the Fed were only using world equity prices as an indicator, and were not specifically concerned with altering US stock market outcomes on this day, Tuesday, January 22, 2007, they would not have scrambled over a holiday weekend, perhaps over a single long night, to put together a virtual FOMC meeting prior to market open on a cold, tired winter morning. Nor is this the first time the Bernanke Fed has behaved this way. By my count this is the third unexpected pre-market announcement issued by the Bernanke Fed following indications of turmoil in equity markets. [1]

Let's recall what William Poole, President of FRB St Louis (and, interestingly, the only dissenter to this morning's move) said in November, 2007 about the "Fed put":

I can state my conclusion compactly: There is a sense in which a Fed put does exist. However, those who believe that the Fed put reflects unwise monetary policy misunderstand the responsibilities of a central bank. The basic argument is very simple: A monetary policy that stabilizes the price level and the real economy cannot create moral hazard because there is no hazard, moral or otherwise. Nor does monetary policy action designed to prevent a financial upset from cascading into financial crisis create moral hazard. Finally, the notion that the Fed responds to stock market declines per se, independent of the relationship of such declines to achievement of the Fed’s dual mandate in the Federal Reserve Act, is not supported by evidence from decades of monetary history.

Poole is quite clear that he believes it is within the Fed's mandate to use monetary policy "to prevent a financial upset from cascading into financial crisis". That's a plausible view of what the Fed is after with its surprise, early morning interventions.

Poole goes on to say...

From time to time, to be sure, Fed action to stabilize the economy—to cushion recession or deal with a systemic financial crisis—will have the effect of pushing up stock prices. That effect is part of the transmission mechanism through which monetary policy affects the economy. However, it is a fundamental misreading of monetary policy to believe that the stock market per se is an objective of policy. It is also a mistake to believe that a policy action that is desirable to help stabilize the economy should not be taken because it will also tend to increase stock prices.

Reviewing these two snippets reveals what I think are fatal tensions in the Fed's practice of asymmetric macroeconomic stabilization (stimulate busts but never prejudge a boom a bubble). Poole is at pains, throughout his talk (whose theme is moral hazard) to claim that stabilization policy uses the stock market as a instrument of policy, but that this does not imply that the stock market can use the FRB as a backstop or guarantee. In the question of who's using who, Poole wants to make it clear that the FRB is the boss. But, if the Fed must intervene to prevent "panics", it has placed itself in the role of a parent habitually blackmailed by a self-destructive adolescent. "If you don't give me what I want want Mommy, I'll cut myself and maybe I'll die!" As too many parents know, it's a bad situation, precisely because the threat of harm can be credible. One can't condemn a parent for capitulating in any particular squabble. But, it's also obvious that this is a bad dynamic, one that shouldn't be lauded as the cutting edge of "intelligent macrofamilial stabilization policy." It's not a particular policy action that's bad, it's the macroeconomic game that we've settled into that has to be changed if we want markets that aggregate external information and make wise allocation decisions rather than focusing on intrafinancial Kremlinology.

I'm not optimistic that the current Fed will transcend heroics and push towards a new dynamic. The Great Depression haunts the Fed chairman like the memory of an older sibling's suicide. The troubled younger child will be coddled and indulged, and fingers will be wagged only when it is very safe to do so. But, tragically, indulgence and capitulation don't always work, what appears to be the least risky course can sometimes be a sure route to escalation and destruction. When the last child died, it was blamed on tough love. But that might not be right, or if it was, it might say little about what this child needs.

Anyway, I think recent events have shown pretty clearly that a Fed put does exist. The Fed can be counted on quite specifically to try to forestall extreme lower tail outcomes on very short period US equity returns. That doesn't mean the Fed is setting a floor under long-term asset prices. They might soberly stand aside as markets fall by 60% over a period of months. But they don't want it to happen in a day. Long-term, buy-and-hold investors should take little comfort. But short-horizon traders have every reason to truncate the lower tails of the subjective probability distributions that guide their moves.

Still, though Bernanke & Co may fully intend to try, there's no guarantee that the Fed will succeed at preventing sharp drops or sudden stops. The Fed is doing its best to offer traders a put, but as markets are now learning, counterparty risk can be a bitch.

[1] The first surprise intervention was the announcement on August 17 of the cut in the discount window spread from 100 to 50 bps following an overnight crash on Asian markets. The second was the Fed's announcement of the TAF and central bank coordination on December 12, following a disappointed reaction in equity markets to a fed funds cut of "only" 25 bps. The third intervention was today's. The timing of the Dec 12 announcement may have been a coincidence not much related to equity prices behavior, but the Jan 22 and Aug 17 announcements were, in my opinion, clearly intended to affect US stock markets.

I was reading Greg Mankiw dissing a tax increase proposal by Hillary Clinton, and I thought to myself, "If I could invent a tax increase for Greg Mankiw to dis, what would it be?" Suddenly, the screen began to waver, dreamy harp music chimed, and a vision appeared to me on a tablet of balance sheets: Eliminate the tax deductibility of interest payments by businesses. Debt financing externalizes the risks of business activity and magnifies social costs, while equity financing concentrates risk among stockholders who signed up to bear it. Yet under current rules, taxpayers literally pay firms to get rid of stockholders and take on ever more debt.

Here's the case-in-brief:

Creditors (people who lend to a firm) and equityholders (those who own stock) are fundamentally the same thing. Both are just investors, people who place money in the hands of a firm in hopes of getting it back later on, with a little something extra for their troubles. Whether one chooses to invest as a stockholder or bondholder is an idiosyncratic matter. Bondholders sacrifice potential upside for predictability and a legal right to enforce payments. Equityholders have no guaranteed payment schedule, but retain a potentially unlimited claim on a firm's future success. Firms pay bondholders according to a predetermined payment schedule, interest and principle. Equityholders are paid via dividends or share buybacks, but only when management is confident it has sufficient resources to pay debt obligations and fund firm operations. For those who grew up in the era of structured finanace, the equityholder/bondholder distinction is basically a primitive version of the tranching you'd find in a CDO. (There is the control thing that, as a historical quirk, usually goes exclusively to equityholders, but we'll put that aside for now. Creditors "own" a company as much as shareholders do, though the two groups have different sorts of rights associated with their claims.)

You'd think that the organization of investment contracts would be a private matter between people with money and people with good ideas about how to use it. But, that's not the case. Large-scale investment is crucial to a modern economy, and getting investors to trust strangers enough to give them their money is hard. So pretty much every government takes an interest in helping things out. Governments define forms of business organization, enforce accounting standards, and develop a body of law that mediates between managers and the various classes of investor. To overcome some of the trust issues, the most nervous sort of investor, bondholders, are given the business equivalent of a doomsday device to enforce their claim on timely payments. If, of malice or misfortune, a firm fails to pay out as promised, bondholders can force a firm into bankruptcy and coercively try to recover what they're owed. Though bankruptcy may be in bondholders' interest, it is quite traumatic for other firm stakeholders. There are two facts we should take note of: 1) bondholders owe an especial debt to the state, as the state, often at great cost, much more aggressively enforces creditors' rights than the rights of other investors; and 2) from a systemic perspective, a great predominance of bondholders — too much debt financing — is dangerous.

When an equity-funded firm underperforms, that mostly is a private matter that harms stockholders who knew the risks they were signing onto. When a debt-funded firm underperforms and cannot meet its obligations to bondholders, a sharp "nonlinearity" is provoked that frequently results in widespread harm to a firm's employees, suppliers, customers, and the communities in which it operates. If debt financing is very prevalent within the firm's "ecosystem", one firm's bankruptcy may cascade into widespread, even systemic, crises. Fundamentally, the right of bondholders to enforce their claims via bankruptcy is analogous to limited liability for investors of all classes — it's a legal convention we've developed to encourage socially useful risk-taking that partially externalizes the downside risks for some investors. While equity-funded firms fail as well, they have more leeway to temporarily underperform and recover, and the impact on firm stakeholders is usually more gradual and predictable.

Don't get me wrong. The existence of enforceable debt financing is a very good thing. It's an essential element of the constellation of institutions by which we are able to fund large-scale capital-intensive projects without coercion. But, the public incurs costs and risks by promising to enforce debt contracts. If a project is going to be funded regardless, any state meddling in capital structure ought to tilt the scales towards equity rather than debt financing.

But that's not what happens. Instead, corporate tax law strongly favors debt financing. One way or another, firms have to pay their investors. When firms pay stockholders, every dollar an investor receives drops off the firm's balance sheet. But when a bondholder receives the same dollar, a US firm pays as little as 65¢. The other 35¢ is paid for by Uncle Sam, in the form of a tax deduction. This creates a great incentive for firms to buyback shares and borrow money, that is to convert from equity financing to debt financing, when times are good and thoughts of bankruptcy seem remote. For example, here's Brad Setser, writing today about how the world looked one year ago:

There was no real risk to taking on more debt to reduce the amount of outstanding equity on a firms balance sheet and, in the process, increase the return on existing equity. Private equity firms had shown the way to arbitrage the difference between the pricing of debt and equity; all that remained was for everyone else to follow suit.

According to canonical financial theory a firm's debt/equity split, or "capital structure", should have no effect on overall firm value. It's just different ways of slicing up the same money pie, in a common metaphor. But if you introduce tax deductions for debt payments, the equation changes. Then the theory predicts that a rational firm should load up on debt financing, in order to capture the benefit of the "interest tax shelter". If bankruptcy were not an issue, rational firms would move to ~100% debt financing in order to extract the largest possible subsidy. With bankruptcy a possibility, a rational firm loads up on debt until the marginal increase in bankruptcy risk outweighs the marginal benefit of the subsidy. But if imperfect managers underestimate bankruptcy risk during periods of stability, they may unwittingly (or purposefully, if there are agency problems) bring firms close to the brink, provoking traumatic failures when the gales of an untamed business cycle blow strong and hard. By covering a large fraction of corporate interest payments, the government effectively subsidizes financial risk-taking that serves no operational purpose but generates real social costs.

So, here's my proposal: Put payments to stockholders and payments to bondholders on a level playing field. Eliminate the tax deduction for business interest payments. I'm not sure how much extra revenue this would net the Treasury, but by ending a perverse incentive for firms and eliminating a large subsidy to the wizards of debt, it would pay off hugely in the form of a more stable corporate and financial environment.

Note: Another way to level the playing field between debt and equity financing would be to eliminate corporate taxation entirely. I'd be cool with that too, as long as it was accompanied by a tax increase elsewhere whose incidence is at least as progressive as the corporate tax. Actually, eliminating the corporate income tax while making up the difference with a surge in top income tax brackets would be a fine stealth bailout for stock markets, funded by really rich people. Stocks would instantly be more valuable! And really, if we are going to socialize the costs of our financial meltdown, shouldn't we socialize it disproportionately to the people who gave it to us?

I really dig Andrew Clavell. But he is misguided in his criticism of an excellent piece by Martin Wolf.

Here's Andrew:

[I]ndividual mortgage borrowers demanded their chance to improve their social and financial standing with scant regard for the potential consequences of their actions. MBS Investors (read hedge funds, money market funds, pensions, mutual funds as well as banks) demanded 'attractive' yields for the perceived risk, and had incentive structures and abundant liquidity available to encourage risk taking.

Mortgage borrowers and mortgage-asset investors were both long housing assets, the former with a call option on the upside, the latter by shorting puts on the downside for yield premium. Investment banks, at whose doors Mr Wolf et al are laying the blame for the outcome of this misguided speculation, just saw an opportunity to intermediate this activity and did so successfully. It was their own badly conceived warehousing of some of the assets which is causing them so much mark to market pain at present, but that is not the issue.

Are we supposed to blame the bankers for being oil in the cogs in the capitalist engine? Are we suggesting that banks should have desisted as they knew a bubble was developing? Why are we ready to pronounce them the bad-guys again? Purely since their pay is the most public and the most despised by outsiders. So let's regulate it. Claw it back. Withhold it for 10 years.

Never mind that politicians and central bankers set the tone for investors (loosely, the American dream). They don't get paid much, so let's not blame them. Let's also not claw back their salaries or appropriate large fractions of their fees from lucrative speaking tours or book sales following their exit from public duty.

Never mind that the majority of ordinary people are illogically risk seeking in housing markets, or dot com shares. Ordinary people don't get paid like bankers, so let's not blame them. Let's not try to educate ourselves properly about finance before we wreak such destruction.

Never mind all that. Blame the intermediary who earned too much.

Andrew is quite right to note that there is plenty of blame to go around. Ordinary folk herded into scam mortgages, taking a rational bet that this year would be like last year and they could catapult themselves into the upper middle class by taking a chance on the biggest home they couldn't afford. Institutional managers herded into structured products promising high yield at next to no risk, products that seemed to violate the most elementary rule of finance (no arbitrage), and were shocked, shocked when after four years of great bonuses, their clients learned there was risk after all. And bankers of all ilks and alphabets, I-bankers, C-bankers, M-bankers, discovered there was great money to be made, intermediating (originate and sell!), dealmaking (LBOs, baby, it's a new era of infinite leverage and no defaults!), and shoving risks where stockholders and regulators couldn't see them (SIVs are just innovative!). People who face opportunities with stratospheric upsides and largely externalized downside costs take chances. Fundamentally, the behavior of bankers was no different than that of homebuyers with dollar signs in their eyes, the guy who ran a "mortgage company" from an e-mail server in his basement, or you and me in their situation. So, why should we pick on them?

We should pick on them. It's not because they're bad people. Most bankers are very nice people. We should pick on them because, as Andrew says, banks intermediate. They are a point where all the lunatics meet to transact, a point where applying pressure can change everything. We can rant and rail against human nature, but who cares? People is people, God bless 'em. But banks are formal institutions, amenable to laws, regulations, and litigable norms and standards that are easily reshaped. We don't have to throw up our hands at frailty and corruption and watch reruns from the 1930s over and over again. We can actually mess with banks (and other financial intermediaries) in ways that indirectly shape the behavior of the rest of us (and that are not terribly intrusive to most of us). It simply isn't true, in the general case, that human desires are exogenous and "demand will find supply". The explosion of misbehavior on all sides of the credit market over the past several years was not caused by a burst of theta-waves from the Earth's core. We allowed our institutions to evolve to a place where misbehavior was ordinary, caution uncompetitive, prudence a firing offense. If we change the institutions, we change the behavior. We can do that, and we should do that.

I'm skeptical of proposals (by Wolf and others) with regard to bankers' pay, not because they are harsh, but because they are circumventable. Escrowed cash and restricted stock can be pledged and hedged, regardless of formal prohibitions. (We simply haven't invented a decent compensation instrument that can't be cashed out. That would be a profoundly useful financial innovation.)

Unsurprisingly, when Martin Wolf and Andrew Clavell agree, it's worth paying attention. Wolf:

An alternative suggestion is “narrow banking” combined with an unregulated (and unprotected) financial system. Narrow banks would invest in government securities, run the payment system and offer safe deposits to the public.

Wolf backs off of this suggestion far too quickly. ("The drawback of this ostensibly attractive idea is obvious: what is unregulated is likely to turn out to be dangerous, whereupon governments would be dragged back into the mess.") Much of this danger could be ameliorated with one parsimonious regulatory principle for the nonbank financial sector — An absolute prohibition on scale. There should be hard limits on the quantity of gross assets under any one entity's control, combined with strong norms of independence (copycat investing is prima facie poor practice that opens up managers to investor lawsuits), along with antitrust like scrutiny of coordinated action. This would represent a big change. The current legal environment creates artificial economies of scale (the complexity of securities law), rewards herding ("safe harbor" provisions, "Nationally Recognized Statistical Rating Organizations") and punishes independence (managers who make unusual choices face investor liability). The maximum permissible size should be absurdly small by today's standards.

Obviously, this is a radical proposal, unlikely to happen anytime soon. But we may yet get to the point where all our choices are scary, so we'd best have some good options ready to go, just in case. One way or another, we have got to improve a financial sector that extracts a large fraction of collective wealth, allocates capital poorly, and creates periodic bouts of instability and human misery. Most of the men and women who work on Wall Street are fine people. But in Manhattan as much as in Michigan, broken institutions ought not be protected from bouts of creative destruction. America's vaunted financial system does not adequately serve the purposes it is meant to serve. That has to change. Ideally, we should encourage private innovation and follow a cautious, incremental path to something better. But regardless of how we get there, a lot of people who have been well compensated under existing arrangements aren't going to like the changes. Too bad.